In recent months economists have consistently pointed to the housing market as a sign of economic strength. And it is…unless you don’t own a house. But more on that in a minute. Remarkably, housing prices haven’t skipped a beat throughout the COVID-19 crisis despite a 32% drop in new & existing home sales from February to May (transactions have since fully rebounded). Prices have been supported by very low supply; ultra-low mortgage rates; mortgage forbearances associated with the pandemic; and a spike in personal income driven by massive COVID-related government transfer payments (expanded unemployment benefits and stimulus checks). The strength in housing prices has supported the economy both directly and through the wealth effect, which simply postulates that consumers will spend more freely if they believe their assets are worth more. However, the bull market in housing is also highly unusual given the depth of the economic contraction. And while the building froth is nowhere near the levels seen prior to the GFC, there are some causes for concern.
First, the US banking sector is heavily exposed to residential mortgages, including home equity loans and HELOCs. So far, loan losses have been modest thanks in large part to government transfer payments and the moratorium on foreclosures. However, Congress has been unable to pass another round of stimulus, and the foreclosure moratorium, extended last month, is set to expire at the end of the year. If job growth doesn’t accelerate soon and/or government support is not extended, bank losses may increase. Higher loss rates won’t cause the kind of banking crisis we saw in 2008-2009, but a spike in losses will inhibit bank lending during a critical time in the economic recovery.
Our second concern is that the Fed’s suppression of interest rates leaves the housing sector, and the economy at large for that matter, even more dependent on ultra-low interest/mortgage rates. The Fed continues to paint itself into a corner by using interest-rate suppression to generate economic activity. Since a dearth of low-cost capital is not what ails the economy, the economic support the Fed seeks is manifesting in the form of rising asset prices. We’ve seen many times in the past, most recently in late 2018, that any effort by the Fed to “normalize” interest rates is met with a fast and furious hit to asset prices. Is there any reason to believe this time will be different?
Finally, continued increases in housing and other asset prices in the face of widespread unemployment is exacerbating the problem of economic inequality. Specific to the housing sector, the growing cost of ownership is not only locking some lower-income folks out of the purchase market, but it is also leading to rent increases as landlords are forced to cover their rising cost of ownership. The US Department of Labor accounts for the cost of shelter through “Rent of Primary Residence” and “Owner’s Equivalent Rent”, the latter of which approximates the “rent that would have to be paid in order to substitute a currently owned house as a rental property” (Investopedia). The chart below shows that despite a deceleration in growth, the cost of shelter has been growing well in excess of the overall CPI for a long time. In the most recent CPI report for August, the cost of rent and owner’s equivalent rent rose 2.9% and 2.7%, respectively, compared to August, 2019 – well ahead of the Fed’s target of 2%. These increases are obviously having a much larger effect on the lower- and moderate-income populations, exacerbating inequality. How much will shelter costs grow if interest rates start to rise?
The growing problem of economic inequality will be one of the major challenges for the next administration. Rightly or wrongly, many Americans associate home ownership with the “American dream.” And while there is certainly no entitlement to a nice single-family house with a yard written in the Constitution, the growing inability of many Americans to access that dream of homeownership may be another sign that inequality is getting to unsustainable levels.
The housing market’s strength has been a positive for stocks, but it warrants careful monitoring. Absent significant additional fiscal support, we may begin to see why the banking sector is trading at such low valuations. And the spillover effect to consumer spending and other sectors of the economy could be significant. Just another reason to maintain a defensive posture during these turbulent times.